Projected state and local revenue shortfalls are shrinking, but the value of substantial federal aid to state and local governments is not

Recently, a number of analysts have noted that the revenue shortfall for state and local governments stemming from the COVID-19 economic shock looks to have been smaller than what was forecast in the middle of last year. However, these smaller revenue shortfalls should not deter federal policymakers from including substantial aid to state and local governments in the forthcoming relief and recovery package, for a number of reasons:

  • The revenue shortfall is smaller than forecast in the middle of 2020 because the economic fallout of the COVID-19 shock has fallen so heavily on low-wage workers. While this has blunted the revenue loss because low-wage workers pay fewer taxes, it has increased fiscal demands on spending by an abnormally large amount.
  • The fiscal demands on the spending side of state and local budgets should not be defined simply by what these governments provided in public investments and safety net spending in the pre-COVID status quo. The need to “build back better” is real and should influence future plans for state and local spending.
  • Building back better will require more public investments—particularly in education and safety net programs. Crucially, large educational investments are needed just to keep educational quality constant. These investments have lagged in recent decades.
  • Currently, the federal aid to state and local government in the Biden administration’s American Rescue Plan (ARP) provides two utterly crucial functions: It is the major provision that offers potential financing for public investments, and it smooths out the disbursements of aid, allowing the aid to be distributed more gradually and hence buoy growth for a longer stretch of time over the coming years. Just stripping this aid out (or significantly reducing it) would hence be extremely harmful to the overall effectiveness of the ARP.

The low-wage focus of the crisis has been good for state and local revenue, but desperately calls for more spending

State and local revenue shortfalls in 2021 so far look significantly smaller than those forecast in the middle of 2020. Smaller shortfalls are good news, but they don’t justify inaction or mean these state and local governments are facing no forthcoming fiscal stress. The shortfalls forecast in the middle of 2020 would have been, by far, the largest in U.S. history. The shortfalls at the time were large enough to—by themselves—cause a jobs shortfall of over 5 million jobs if they weren’t filled. This jobs shortfall would have been larger than total employment loss of any recession since the Great Depression except for the 2008–2009 Great Recession. This was emphasized this week in a report by Moody’s Analytics. In highlighting the reduced estimates of these revenue shortfalls, Moody’s noted: “This resulted in smaller shortfalls than originally anticipated in most states, but the overall magnitude of the revenue stress is still historic.”

Moody’s—as well as many other sources—have noted two key reasons why the aggregate state and local shortfall has been smaller than forecast before: (1) Federal income support for households has been historically large over the past year, buoying tax collections at the state and local levels; and (2) much of the economic damage of the COVID-19 shock has fallen far harder on low-wage workers than in past recessions. As they note, “It has been unique in the way that budgets are being impacted, with a substantially larger share of overall stress coming via spending pressures than is usual, particularly among social service programs.”

While the focused damage on low-wage workers has blunted state and local revenue losses, it has greatly increased demands on the spending side of state and local budgets relative to previous recessions. To take just one example, Medicaid enrollment growth over the pandemic looks set to be larger than growth during previous recessions. As Medicaid is one of the largest drivers of state budgets, this highlights how needs have grown on the spending side of budgets.

‘Build back better’ will require more public investments

Crucially, the spending needs facing state and local governments should not be defined by the pre-COVID status quo. The Biden administration has often highlighted the need to “build back better.” This should mean a better functioning and more generous social safety net and increased public investments. The Moody’s report is very clear that its current estimates of the fiscal stress facing state and local governments do not include this aim to build back better. For example, the report notes that:

This undoubtedly represents a best-case scenario, as it accounts only for fiscal stresses resulting from the weaker pandemic economy and does not account for extra spending pressures outside of social services. For example, it does not include new needs for implementing IT enhancements or facility upgrades to account for social distancing measures or virtual workplaces. It also, outside of Medicaid, does not account for public health spending increases as a result of the pandemic.

By far the largest public investment financed by state and local governments is education, both K–12 and higher education. It is a well-known finding in economics that the cost of providing public education is likely to rise faster than overall economic growth over time. This finding, sometimes known as “Baumol’s Law,” highlights the fact that some sectors in the economy—like education or health care or other in-person services—are more resistant to automation and other sources of productivity growth. This means that the relative cost of these sectors will rise over time. In turn, even if the inflation-adjusted output of these sectors does not rise, their rising relative costs lead to them accounting for a larger share of total output. Given that many of these productivity-resistant services are those provided by the public sector, this means that the public sector share of economic output should rise over time.

One concrete manifestation of this can be seen in teachers’ compensation. Public school teachers are highly educated and skilled. Pay for workers like them throughout the economy tends to rise steadily over time. If the pay of teachers does not rise in tandem, it will be harder and harder to continue to attract and retain enough skilled teachers. In short, simply to keep educational quality constant, it will require state and local spending on education to rise as a share of the overall economy over time, just to keep teacher pay from falling relative to developments for similarly skilled workers in the private sector. In recent decades, this has clearly not happened. In fact, over the recovery and expansion following the Great Recession, state and local spending on education actually declined in absolute magnitude for long stretches, and certainly did not rise as a share of the economy’s potential output.

This same logic of Baumol’s Law applies to health care, another of the huge expenses on state and local budgets. Additionally, the decades-long reduction in state and local funding for higher education has translated directly into rising tuition costs facing U.S. families. These costs have driven the increase in student debt over this time, which has in turn fueled fierce debate over debt forgiveness. Whatever the merits of debt forgiveness (and we think it is necessary), there is no defensible reason to not at least rein in the growth of future debts driven by ever-rising tuition costs. The single most effective step in reining in tuition cost growth and stopping future student loan debts from being racked up is precisely to increase state and local investments in higher education.

In short, defining shortfalls in the fiscal capacity of state and local governments should not be based only on a pre-COVID status quo that was inadequate in the first place. Instead, they should be defined based on the portfolio of safety net spending and public investments these governments should be providing.

The role of state and local aid in the American Rescue Plan is not easily replaceable

The proposed ARP has generated intense debate in recent weeks. The least convincing critique of it is that it is “too large.” More valid concerns are that it does not contain explicit public investment measures, and that it could in theory be too front-loaded and not leave enough fiscal support 12 or 18 months from its passage when the economy could still use it.

These last two concerns are largely addressed by the large role of federal aid to state and local governments in the ARP. Most public investment is currently directed by state and local governments, so providing them more fiscal capacity greatly expands the possibility for the ARP to provide a big boost to public investment. And the disbursement rate of the state and local aid in the ARP will be longer-lasting than some other parts of the plan. This is useful—we want the $1.9 trillion to be spread a bit over the next couple of years to avoid a whipsaw of aid dropping at once and then turning off.

If the state and local aid is just removed or significantly scaled back, then the package would contain substantially less support for public investments and be more front-loaded than is optimal. In short, scaling back this aid would make it a significantly worse package.

The concentration of economic pain on low-wage workers combined with extraordinary fiscal support over the past year have kept state and local revenue shortfalls from becoming as large as it was once feared. This should not, however, be taken as a reason for complacency. Instead, it should be taken as an opportunity to genuinely use the ARP (or something like it) to “build back better.”